Global Venture Capital: History, Trends, and Economic Impact

Introduction to Venture Capital

If there is one universal attribute that applies to all investors, it is the undying thirst for higher returns. Venture capital (VC) is founded on this fundamental premise, as it has great potential to provide returns far in excess of conventional methods of investment. What makes VC so important is that it is often the only source of funds for new entrepreneurs, as banks and financial institutions provide finance only against securities or guarantees. VC has grown from a small investment pool in the 1960s and 1970s into a full-fledged investment tool and a key element in corporate and institutional investment portfolios.

The term "venture capital" is often used interchangeably with private equity investing, which encompasses venture investing and buyouts. The astonishing growth and success of new-generation companies such as Apple, Intel, Federal Express, Microsoft, Yahoo, and Cisco is a sterling tribute to VC, as these companies received venture capital in their early stages of development. The singular difference between VC and other forms of financing is that VC provides money to firms whose success is not guaranteed; in fact, there have been instances when firms had to be funded even prior to formal incorporation.

VC investments are characterized by high uncertainty in terms of technology risk, product market risk, management risk, and liquidity risk. A major distinction lies in the relationship between investor and investee in a VC transaction. While on a commercial plane they are bound by a mutual interest in economic benefit, on a legal plane their interests can diverge. For the investor, profits and a timely exit from the venture are of paramount importance. The investee would like to retain a continued role in the company. This requires the investor to respond to the challenges of various contingencies that may arise once the funding process is set in motion. Unlike conventional lending, the only protection for the investor is to ensure that the venture stays on track and succeeds in time, which may prompt the investor to exercise controlling rights when things go wrong. This is perhaps the single biggest challenge that can make or break a venture capital transaction.

A common perception of venture capitalists is that of a wealthy financier on the lookout for start-up ventures in which to invest, hoping for abnormal profits at some future point. The reality is far different. Professional venture capital firms are closely held corporations or private partnerships funded by public and private pension funds, endowment funds, corporations, wealthy individuals, and foreign investors. Not all venture capitalists invest in start-ups; a rational venture capitalist will strive to maintain a balanced portfolio that levels out risk and ensures a net positive return. VC firms also specialize in other investment alternatives such as initial public offerings, mergers, and acquisitions.

Venture capital is a form of equity finance that took solid root in the post-World War II years, especially in the United States. From a relatively small scale in the 1960s, the venture capital industry now spans almost all sectors of business and the broader economy. In the last four decades, American venture capitalists have proved time and again that VC can be the prime vehicle for economic growth even in times of recession. Other countries — including European nations, Canada, Australia, and Asian nations — have grasped the significance and potential of VC financing. The philosophy of VC is best described by an old saying: "the biggest shortage is not capital, but people with the right know-how." As VC markets advance and mature across the world, the challenge facing investors and companies seeking funds is to fully understand the dynamics of VC so that mutual objectives are realized.

Definition and Lifecycle of Venture Capital

Venture capital is money provided by professional investors who invest alongside management in start-up, young, and rapidly growing companies that have the potential to develop into highly profitable ventures. There are many popular perceptions of venture capital, and formal definitions are not always easy to find. A widely discussed definition is that offered by Dr. Neil Cross, former Chairman of the European Venture Capital Association. According to this definition, venture capital is the provision of risk-bearing capital — which may take the form of equity participation — in companies that have high-growth capacity. The basic characteristic of venture capital is that it is a form of equity finance, participatory in nature, with a long-term maturity horizon. Venture capitalists require a high rate of return as a trade-off for the degree of risk involved and the patience required before returns materialize. The generally expected return is approximately 40% per annum, compounded (Bovaird, p. 33).

VC financing is provided in several stages based on a pre-agreed schedule tied to well-defined milestones. A venture capital lifecycle has seven stages: seed capital, start-up capital, early stage finance, second round finance, expansion capital, management buyouts and buy-ins, and mezzanine finance. As the name implies, seed capital is provided for initial product development, or as the finance given to an entrepreneur to establish the feasibility of a proposed project and qualify for start-up capital. The second stage, start-up capital, is for product development, initial marketing, and setting up production facilities. Early stage financing is provided to firms that have passed the product development stage and require funds to commission commercial production and sales.

As the firm expands, it may need additional capital, which is provided through second round finance. When the firm reaches breakeven or has begun generating small profits, it will need funding for further expansion. This critical requirement is met by expansion capital, which drives the firm toward maximum profitability. A management buyout is the finance granted to the firm's management and investors to acquire an existing product line or business. The management buy-in, by contrast, provides funds to managers outside the firm to buy into it with the support of venture capital investors. Finally, mezzanine financing is provided to enable the firm to complete a trade sale or proceed with a public flotation of its shares. Mezzanine financing is offered either in the form of debt or high-ranking equity.

Legal Structure of VC Firms

VC firms operate in many forms, but most are organized as limited partnerships in which they serve as general partners. A common type is the private independent firm, which has no affiliation with any financial institution. Apart from limited partnerships, which remain the dominant form of VC organization, governments have permitted formation of either Limited Liability Partnerships (LLP) or Limited Liability Companies (LLC). A VC firm can choose its organizational style based on considerations of management responsibility, liability, and taxation. Typically, the VC firm organizes the partnership as a pooled fund comprising the general partner and the investors, or limited partners. These funds are fixed-life partnerships, with a normal life of ten years; each fund is capitalized by investments from the limited partners. Once the partnership attains its targeted size, it does not accept further investment, and the fixed capital pool is deployed for investments.

In another form, VC firms may be affiliates or subsidiaries of commercial banks, investment banks, or insurance companies, making investments on behalf of parent entities. These are commonly known as "corporate venture investors" or "direct investors." This form of investing was quite popular in the 1980s and has been returning to vogue. In this case, the objective is to identify and invest in opportunities that align with the parent entity's business strategy. Such firms may also invest to secure access to superior technology or to achieve cost savings in their operations. A major feature of corporate venture investing is that the primary objective relates to corporate strategy rather than purely financial considerations.

The activities of venture capitalists generally include financing new and growing companies and acquiring equity securities with a long-term perspective. Venture capitalists thus take on higher risks with the expectation of higher rewards, which cannot be provided by other forms of investment. Before investing, venture capitalists conduct a thorough analysis of the investee company's business model and estimate future returns. They take an active interest and work closely with investee company management, offering expertise gained from assisting other companies through their growth stages. As part of risk diversification, VC firms typically invest in a portfolio of young companies under a single fund, and it is common for them to invest as a syndicate with other professional VC firms. Venture partnerships often manage multiple funds simultaneously to spread risk and maximize returns.

Typical venture capitalists examine many investment opportunities before selecting a group of companies in which to actually invest. They look for a high rate of return — much higher than most other investment options — within a span of five to seven years. This motivates venture capitalists to be more than just financiers: they involve themselves deeply in the management, strategy, and operations of the companies they back. It is this entrepreneurial spirit that distinguishes venture capitalists from conventional lenders such as banks and financial institutions. Although they involve themselves in the affairs of investee companies, most venture capitalists seek to exit once they have realized the desired rate of return, enabling them to reinvest in other young companies and continue generating higher returns.